Investing in Startup Companies [Ground-Floor Investments]

Have shows like Silicon Valley and Shark Tank piqued your interest in investing in startups? Or is one of your friends invested in a startup and is raking in fantastic returns, and now you want a piece of the startup action?

Startup investments can be high risk, but they can also be high reward. Just imagine how rich you’d be if you were able to get in on the ground floor of, say, Amazon (AMZN) or Apple (AAPL).

Before you dive into startup investing, however, it’s essential to know the pros and cons of investing in new companies, the different ways you can invest, how it differs from public market investing, and more.

Let me steer you through the basics of this lucrative but very “Wild West” investment type. Read on to get a good idea whether investing in startups is a wise choice for you, and, if so, which kind might be the best fit, and how to get started.

Ways to Invest in Startups—Our Top Picks

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Who Qualifies to Get Into Startup Investing?

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Due to the risks involved and the high price of entry, the vast majority of startup opportunities are only open to investors with deep pockets. Known as accredited investors, in short, these folks are people with high incomes or net worths of $1 million or more.

If you don’t qualify as an accredited investor—and the majority of people don’t, so you’re in good company—take heart. You can still find a few ways to gain access to startup investing (albeit on a more limited basis) through crowdfunding platforms.

Related: 14 Best Investment Opportunities for Accredited Investors

What Is a Startup Company?

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Startups are fledgling companies in the initial stages of business. These companies are still working on making their business models scalable. They probably have one or two products or services, but that’s about it. They’re still getting up off the ground.

Frequently, a young company’s founders will seek outside funding to help their company grow out of its infancy and gain a foothold in the market.

Many startups never grow past the startup phase (hence the risk!), but the ones that do can sometimes see their company valuation skyrocket, which is good news for investors.

What Is Startup Investing?

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Startup investing is exactly what it sounds like: It’s providing venture capital to a startup to help it grow. (A startup investor is often referred to as an “angel investor.”)

There are two primary ways to invest in startups:

1. You can invest by taking on some of a startup’s debt in exchange for interest payments.
2. You can supply money in exchange for equity in the company.

Startup equity investing means the investors get to own a portion of the company, which gives them rights to some of the future profits. Equity investing is the type you frequently see on the show Shark Tank.

Equity startup investors typically profit from their investments when they sell all or part of their stake during a liquidity event, such as a subsequent funding round, initial public offering (IPO), or acquisition.

Liquidity events aren’t frequent, so startup equity investing is considered an illiquid investment.

Another way to invest in a startup is through private debt. With private debt, you take on the responsibility to pay for some of the debt the startup has already accumulated. In exchange, you receive regular interest payments. The startup company borrowing the money must pay you and other lenders back—but if the startup fails, you could get much less back than you lent.

It’s common for debt investors to set requirements for startups they’re working with, such as that the startup must maintain a minimum cash balance. Debt investments from startups offer better liquidity than equity investing.

Related: How to Invest in Private Investment Funds

What Is a Liquidity Event?

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Startup liquidity events let company founders and angel investors convert illiquid equity into cash. Liquidity events represent exit strategies for startup investments.

There are several types of liquidity events, such as additional venture capital raises. Each round of funding is designated with a letter (Series A, Series B, etc.)

Initial public offerings (IPOs) are another liquidity event. Companies raise capital during an IPO by issuing shares of stock or equity to the public for the first time. Private backers can sell all their equity, or just part of it, alongside the company during this time, if they so choose.

Some startups provide equity investors with right of first refusal (ROFR, pronounced “roafer”) when shares are sold. If shareholders want to sell stock, they must give the angel investors or venture capitalists who already own shares and have a ROFR provision the right to buy those shares before they’re sold to a third party.

Sometimes, ROFR only applies when share ownership has reached at least a few percentage points.

Related: Best Cash Alternatives [Get Yield on Short-Term Investments]

What Are the Pros of Investing in Startups?

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• Profit potential: The first pro of startup investing is the most obvious: explosive profit potential. If you invest in early-stage startups, particularly if they are still private, you can enjoy wild growth compared to what you might achieve with more established companies. Whereas many investors can only enjoy gains once these companies hit public markets, you can make substantial returns from a successful startup before it ever goes public.
• Diversification: Another, less obvious pro: Startup investments often aren’t correlated to the stock market, so they can be an excellent way to diversify your investment portfolio. (In other words, they might be able to provide positive returns even if the stock market is down; conversely, though, they might struggle even if the stock market is up.)
• Invest in your values: Aside from that, startups offer the chance to support a company or cause that you believe in. Many people choose investment opportunities where the new product or service strongly aligns with their views. The startup might have an environmental focus, health mission, or be aimed at solving a problem for a marginalized group, such as people with disabilities. The opportunity to help a cause you care about while simultaneously growing your money holds obvious appeal.
• Helps avoid emotion-based mistakes: Startup investing requires a long-term mindset—but its lack of liquidity does have benefits. Namely, it keeps early investors from making rash decisions, which makes it likelier that the investor will hold on as the investment reaches its full potential. Also, startup investing doesn’t require constant action like, say, day trading. And for some, it can be comforting to just sit back and trust the process.

What Are the Cons of Investing in Startups?

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• Risk: The biggest con (by far) of investing in early-stage companies is the risk. The vast majority of startups fail within just a few years, and if a startup you invest in fails before you have a chance to pull your funds out, you could lose most or even all of your money.
• Illiquidity: And as I mentioned earlier, startups are extremely illiquid—so it’s not a great investment strategy if you’ll need your funds in, say, a few months, maybe even just a couple of years. It’s possible you might not see a liquidity event in time.
• Uneven time horizons: Which brings us to another problem: Not only are startup investments illiquid, but the time horizon on them is indeterminate. You need to wait for a liquidity event to trade part of your equity or your entire investment for cash … but there’s no way of predicting just when that event will hit. So only invest in startups if you have funds you’re willing to lock up for years.

How Does Startup Investing Compare With Public Market Investing?

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Startup investing is when you provide capital to a new, private company. Public market investing is when you purchase shares of a publicly traded company.

In both cases, you typically have the potential for significant growth. However, startups typically have more potential upside. Investment experts frequently cite the “law of large numbers,” which effectively dictates that the larger the company, the harder it is to grow. So, for instance, it’s a lot easier for a startup to double its revenues from $1 million to $2 million than it is for a big, established, publicly traded company to double its revenues from $1 billion to $2 billion.

Also, in both cases, it’s possible to enjoy a regular flow of income—investors in publicly traded stocks can collect dividends, while startup debt investors can reap regular interest payments.

You might have much more influence when you invest in startups, including some of the decisions the startup makes. For instance, if you have a significant equity stake, you might hold sway over things like mergers and acquisitions or key personnel.

However, startup investing is also riskier than buying stocks from more established companies.

Also, most startup opportunities are only available to accredited investors and sophisticated investors.

Lastly, startup investing is much less liquid than stock investing. While you can sell stocks at virtually any time, you might have to wait months or even years to unload your equity in a startup.

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How Much Can You Invest in Startups?

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The amount you can invest in startups depends largely on whether you’re an accredited or non-accredited investor, your annual income, and your net worth.

For non-accredited investors, over a 12-month period, the SEC states you must abide by the following:

• Investors with an annual income or net worth under $124,000 can invest “up to the greater of either $2,500 or 5% of the greater of your annual income or net worth.”
• If your annual income and net worth are both equal to or greater than $124,000, you can invest up to 10% of your annual income or net worth, whichever is higher. You cannot exceed $124,000.

For example, if you had an annual income of $150,000 and a net worth of $80,000, the greater amount would be 5% of $150,000, so your 12-month limit would be $7,500.

There are no limits on how much you can invest if you’re an accredited investor.

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How to Make Money Investing in Startups

An accredited investor, with the proper connections and expertise, can be introduced to startup leaders and come up with an investing plan together.

A non-accredited investor who doesn’t have personal connections to startups can use crowdfunding platforms to get started.

Crowdfunding platforms will vet potential startups, giving you the best chance at success. You don’t always need a significant minimum investment to get started, and sometimes these platforms can help keep your money more liquid.

Startups offer several different types of assets to investors, such as equity, debt, convertible notes, and preferred stock. Here’s a look at each:

Equity

Equity investing means you provide a startup with cash in exchange for a proportionate amount of ownership in the business. That ownership might just mean a share in the profits later on, but it could also mean some amount of say in high-level business decisions.

Unfortunately, if you find a startup looking for funding online, it might be a scam. It’s safer to invest in startups where you personally know a founder or use a crowdfunding platform.

Remember: Equity investing is an illiquid investment, so it’s essential not to invest any money you’ll need right away. It can take months, or even years, to get your profits (if there are any).

But for those who can wait it out, the returns can sometimes be substantial. It can also be satisfying to invest in a company whose mission resonates with you and watch it become successful, due in part to your help.

Debt

Investors and debt firms can lend money to startups in exchange for interest payments, much like banks do. Startups like debt funding because they don’t lose equity—and thus they don’t lose control over their company. Investors enjoy this arrangement because they are paid a premium for their money being illiquid.

Typically, debt is thought of as being either short-term or long-term:

• Short-term: Short-term debt is payable in a year or less. (On a balance sheet, this is also referred to as a current liability.) These have lower interest rates than long-term debt and the requirements for collateral are minimal.
• Long-term: Long-term debts have maturities longer than a year. (This is also called non-current liability.) Long-term startup debt investments are raised for capital costs and pay high interest rates. The startup’s assets are used as collateral. You can make more money with long-term debt investments, but your money is also locked up for longer.

Convertible Notes

A convertible note is a type of debt that converts (sometimes automatically) into stock shares when the startup reaches set goals.

For instance, you might spend $100,000 on a convertible note that matures in two years. But you’ll also automatically receive a 25% discounted share rate if the startup raises a specific amount of money during a qualified offering during the note’s term.

If that amount is reached during a qualified offering within the term, the startup would convert your note at the discounted rate. So, say shares normally cost $1 per share—with your discount, you’d be converted at 75 cents per share. Thus, your $100,000 would be converted into 133,333 shares ($100,000 x $0.75).

Preferred Stock

Preferred stock is considered a “hybrid” that acts both like stock and like bonds. For instance, it represents ownership in the company (like “common” stock), but it typically has no voting rights (like bonds). The stock pays a dividend (like a stock), but it’s usually fixed (like a bond’s coupon rate). The reason it’s called “preferred” stock, however, is that preferred-stock dividends are given preferential treatment—that is, they must be paid out before the company pays dividends to common shareholders.

Related: 7 Best Fidelity ETFs for 2023 [Invest Tactically]

Why Invest in Startups?

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Investors gravitate toward startups for several reasons. For most, the main motivator is simple: money, money, money. The monetary gains startups generate can be substantial, because startups have the potential to turn into household names. (Think Airbnb and Uber.)

Investors looking to collect passive income are an excellent fit for debt investing.

Some investors specifically focus on startups where the mission resonates with them. Or they invest in ones they know will create a lot of jobs in their community. In a way, it’s like philanthropy, but with hopes that it’ll also result in a profit.

Being involved in startups can also be exciting as you watch a company grow.

Related: 19 Best High-Yield Investments [Safe Options Right Now]

Should You Invest in Startups?

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Whether you should invest in startups largely depends on your financial situation, risk tolerance, and what you hold in the rest of your investment portfolio.

If you don’t have an emergency fund and aren’t already contributing to a tax-advantaged retirement account, you likely aren’t ready to invest in startups. However, if you already have those bases covered, startups are worth considering.

Startup investing is risky, so only invest in early-stage companies if you are willing to take on a lot of risk. That said, investing in startups has the potential to be extremely lucrative.

This type of investing isn’t correlated with the stock market and it can be an excellent alternative investment if most of your investment profile consists of traditional investments.

Talk to a financial advisor or other investment professionals for investment advice catered specifically to your needs.

Related: 7 Best Wealth + Net Worth Tracker Apps [View All Your Assets]

How to Invest in Startup Equity

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Again, you’ll typically have to be an accredited investor to invest in startups, whether it’s equity or debt. Investing directly in startups can be difficult unless you happen to know someone who just created a company, but several platforms can connect you with opportunities.

EquityBee (Startup Equity)

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Accredited investors interested in startup equity investments can do so easily with Equitybee, a marketplace that connects investors with startup employees who want to extract value from their existing stock options.

Equitybee fields funding requests from people who work at high-growth, venture capital-backed startups. Then, investors in Equitybee’s platform provide funding in exchange for a portion of the employees’ future stock value (pending a successful exit).

Equitybee has connected its investors to successful startups such as Affirm, Unity, Databricks, and 23andMe. Investors can filter through current startup opportunities by industry, venture capital firm, and other vital factors.

The minimum you can invest is $10,000. Equitybee charges a 5% brokerage fee upon funding an employee’s stock options. In the event of a successful liquidity event, investors might also pay a carry percentage of 5% of the remainder in excess of the original investment.

Equitybee is a registered broker-dealer and is regulated by the SEC and FINRA.

Related: 20 Best Investing Research & Stock Analysis Websites

How to Invest in Startup Debt

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Investing in a startup’s debt is different from investing in startup equity. If you want more return potential and have a high risk tolerance, consider investing in startup equity.

Conversely, if you want exposure to startups with greater liquidity potential and high yields, consider debt investing. Rather than trying to find and reach out to startups looking for venture capital on your own, consider using a platform that connects you.

Percent (Private Credit)

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Percent is an investment platform designed for accredited investors who are interested in accessing private credit (non-bank lending).

You can diversify your portfolio with investments such as …

• small business lending in Latin America
• U.S. litigation finance
• Canadian residential mortgages
• merchant cash advances

Percent has built a way for retail accredited investors to access a wide range of private credit opportunities with a clear view into their performance through its innovative tools and comprehensive market data. That allows investors to make better-informed decisions, source and compare opportunities, and monitor performance with ease.

This platform also provides access to an alternative investment that’s a little more liquid than other alts—some debt investments only last nine months, with liquidity available after the very first month in some cases.

The service boasts average annualized returns of roughly 13%, and targets returns of up to 20%. And while investment minimums vary, many Percent opportunities require only $500 to invest.

If you’re interested, visit Percent to learn more or open an account.

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